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HE  ACCOUNTING  TREATMENT 

(27^71    OVERHEAD  CONSTRUCTION  COSTS 

^  IN 

PUBLIC  UTILITIES 


FIRST  EDITION 


ANDERSEN,  DE  LANY  &  COMPANY 

Certifiecl  Public  Accountants 
CHICAGO  NEW  YORK  MILWAUKEE 


GIFT   OF 


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Digitized  by  the  Internet  Archive 

in  2007  with  funding  from 

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THE  ACCOUNTING  TREATMENT 

OF 

OVERHEAD  CONSTRUCTION  COSTS 

IN 

PUBLIC  UTILITIES 


FIRST  EDITION 

Copyright,  1917.  by  Andersen,  De  Lany  &  Co. 
(All  riskts  reserved) 


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ANDERSEN,  DE  LANY  &  COMPANY 

Certified  Public  Accountants 

CHICAGO        NEW  YORK         MILWAUKEE 


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THE  ACCOUNTING  TREATMENT  OF  OVERHEAD 
CONSTRUCTION  COSTS  IN  PUBLIC  UTILITIES. 

Commission  regulation  of  public  utilities  has  brought 
increasing  emphasis  to  bear  on  the  importance  of  overhead 
costs  of  construction  in  valuations  of  physical  property. 
Heretofore  a  lack  of  adequate  records  of  construction  costs, 
together  with  the  common  failure  to  recognize  proper  com- 
ponents of  such  costs,  has  served  to  relegate  to  the  field 
of  engineering  estimate  the  determination  of  overhead 
allowances.  So  diverse  have  been  the  practices  of  record- 
ing many  items  of  overhead  cost  that  the  present  ten- 
dencies as  to  such  items  are  virtually  impossible  of  ascer- 
tainment. 

It  is  the  purpose  of  the  present  pamphlet  to  review  the 
general  practices  and  actual  overhead  charges  in  a  number 
of  utilities  and  to  suggest  a  better  and  more  uniform 
accounting  procedure.  A  study  of  the  following  pages  will 
lead,  it  is  hoped,  to  further  recognition  and  analysis  of  the 
underlying  accounting  principles  so  that  a  better  under- 
standing and  more  careful  application  of  these  principles 
may  result.  It  is  our  intention  to  continue  this  study  so 
that  the  treatment  of  various  overfiead  icharges  may  be 
more  fully  dealt  with  at  a  later  time. 

The  lines  along  which  we  have  proceeded  in  this  investi- 
gation of  overhead  charges  have  been: 

(1)  To  ascertain  the  policies  now  followed  by  utility 

companies  in  the  apportionment  of  overhead 
expenses  between  construction  and  operation. 

(2)  To  ascertain  the  amount  and  nature  of  construc- 

tion overheads  actually  charged  by  a  number  of 
companies  and  the  ratio  of  such  overheads  to 
direct  charges  to  construction. 

(3)  To  determine  whether  construction  items  should 

be  considered  as  overhead  or  as  direct  charges 
in  those  cases  where  the  distinction  is  not  clear. 

In  the  course  of  our  investigation  of  the  policies  now 
followed  by  public  utility  companies  we  sent  out  a  large 


402634 


number  of  letters  of  inquiry  to  various  companies  in  an 
endeavor  to  secure  reliable  information  as  to  their  present 
practices.  Detailed  replies  have  been  received  from  a  large 
enough  number  of  companies  to  justify  the  following  con- 
clusions : 

(1)  Many  companies  have  paid  little  or  no  attention  to 

the  subject. 

(2)  Many  companies  have  not  so  kept  their  construc- 

tion accounts  as  to  be  able  to  summarize  the 
overhead  charges  to  construction  without  con- 
siderable analysis  of  the  accounts  now  kept. 

(3)  Some  companies  recognize  fully  the  importance  of 

proper  apportionment  of  overhead  expenses  and 
are  making  their  best  efforts  to  secure  such 
apportionments  or  are  attempting  to  ascertain 
a  generally  recognized  basis  of  apportionment. 

In  Exhibit  1  we  have  tabulated  the  information  given 
in  thirty  replies  which  gave  most  complete  information 
and  which  were  from  companies  which  appear  to  have 
given  most  attention  to  the  subject. 

The  practices  now  followed  vary  from  charging  the 
bare  prime  cost  only,  in  the  case  of  a  large  number  of 
companies,  to  charging  the  greater  part  of  the  actual  gross 
overhead  expenditures  in  other  cases.  Replies  to  our  in- 
quiries show  very  clearly,  however,  that  companies  which 
have  given  the  most  thought  to  the  charging  of  overhead 
expenses  to  construction  have  adopted  a  conservative  pol- 
icy. Where  there  has  been  a  question  as  to  the  propriety 
of  including  a  doubtful  item  in  the  construction  account, 
the  charge  has  been  made  to  operation.  In  this  way  the 
danger  of  overcharging  construction,  which  is  constantly 
present  because  of  the  pressure  to  keep  down  operating 
expenses,  has  been  avoided. 

Before  taking  up  the  discussion  of  the  suggested  meth- 
ods of  dealing  with  overhead  expenses,  it  will  be  desirable 
to  review  the  procedure  now  followed  by  those  companies 
whose  replies  indicate  that  they  have  made  an  attempt  to 
secure  a  correct  distribution.    Following  is  an  enumeration 


of  various  classes  of  overhead  expenses  with  a  statement 
of  what  seems  to  be  the  current  practice. 

(1)  Engineering: 

(a)  If  a  flat  fee  is  paid  for  a  specific  piece  of  con- 

struction, the  current  practice,  with  very 
few  exceptions,  is  to  charge  the  entire 
amount  to  construction. 

(b)  Those  companies  which  employ  an  engineer- 

ing staff  especially  for  construction  work 
usually  charge  to  construction  the  salaries 
of  the  staff,  its  direct  expenses,  rent  of  its 
quarters  and  incidental  expenses  incurred 
in  its  behalf. 

(c)  Of  companies   which   employ   an   engineering 

staff  which  devotes  part  of  its  time  to  con- 
struction, the  general  practice  is  to  absorb 
all  of  the  expense  of  the  staff  in  operating 
expenses,  although  some  companies  are  mak- 
ing a  division  between  operation  and  con- 
struction charges  on  the  basis  of  the  actual 
time  devoted  to  each  class  of  work. 

(2)  Insurance — 

Injuries  and  Damages: 
The  prevailing  practice  is  to  charge  neither  insur- 
ance nor  injuries  and  damages  expense  to  con- 
struction, although  there  are  exceptions.  In  some 
cases  insurance  is  charged  to  construction  up  to 
the  time  when  operation  of  the  new  equipment 
begins.  Liability  insurance  is  in  some  cases  pro- 
rated on  a  payroll  basis.  Frequently,  of  course, 
no  apportionment  is  needed  as  expenses  on  ac- 
count of  injuries  and  damages  can  be  charged  to 
the  work  in  connection  with  which  they  were 
actually  incurred. 

(3)  Taxes : 

Although  the  general  procedure  is  to  charge  all 
taxes  to  operation,  in  some  instances  taxes  actu- 
ally assessed  on  the  work  in  progress  are  charged 
to  construction  up  to  the  time  that  operation  is 
begun.  Some  companies  follow  the  practice  of 
not  charging  any  taxes  to  construction  on  work 
which  is  completed  within  a  short  time,  although 
they  would  be  charged  on  work  which  requires 
a  long  time  for  completion. 


(4)  Legal: 

(a)  For  companies  whose  legal  work  in  connec- 

tion with  construction  is  done  on  a  special 
fee  basis  the  methods  of  handling  differ. 
Although  some  charge  the  actual  cost  of 
such  legal  service  to  construction,  others 
charge  none  of  it,  and  the  practice  of  others 
does  not  seem  to  be  clearly  defined. 

(b)  For  legal  services  by  members  of  the  com- 

panies* staffs  the  practice  likewise  varies. 
Some  companies  charge  all  expenses  to 
operation;  others  prorate  them  on  a  time 
basis,  and  in  some  instances  a  fixed  per- 
centage of  the  salaries  of  attorneys  is  regu- 
larly charged  to  construction. 

(5)  Storeroom : 

Three  general  methods  of  handling  storeroom  ex- 
penses are  followed.  Many  companies  charge  the 
entire  storeroom  expense  to  operation;  others 
prorate  the  expense  on  the  basis  of  material  han- 
dled, and  still  others  add  a  fixed  percentage  to 
the  cost  of  materials.  In  some  cases  salaries  and 
expenses  of  the  purchasing  department  are  re- 
garded in  the  same  light  as  storeroom  expenses, 
although  the  more  general  practice  seems  to  be  to 
treat  these  items  as  entirely  chargeable  to  opera- 
tion. 

(6)  Utility  Equipment: 

Expenses  of  operating  utility  equipment,  such  as 
wagons,  buggies,  trucks,  automobiles  and  supply 
cars,  with  barn  and  garage  expense  incident 
thereto,  are  in  many  cases  divided  on  the  basis  of 
time  used  for  operation  and  for  construction, 
although  here,  too,  there  are  a  number  of  com- 
panies which  make  no  charge  to  construction. 
In  other  cases  no  such  charge  is  made  unless 
utility  equipment  is  used  on  construction  work 
for  a  considerable  time. 

(7)  General  Officers: 

With  regard  to  salaries  and  expenses  of  general 
officers,  the  prevailing  practice  as  disclosed  by 
the  replies  to  our  inquiries,  is  to  charge  the  total 
to  operating  expenses.  In  the  cases  where  excep- 
tions have  been  noted,  the  practice  of  some  com- 
panies  is   to   base   the   charges   to  construction 


upon  the  amount  of  officers'  time  spent  on  such 
construction,  while  others  charge  a  fixed  per- 
centage of  salaries  of  officers  to  constntction, 
apparently  without  reference  to  the  volume  of 
construction  work  handled. 

(8)  General  Office  Salaries : 

By  far  the  larger  number  of  replies  received  indi- 
cate that  no  charge  whatever  is  made  to  construc- 
tion for  salaries  of  general  office  clerks.  In  a  few 
instances  a  charge  is  made,  based  upon  the  time 
spent  in  connection  with  construction  matters 
and  in  a  few  other  cases,  where  the  entire  time 
of  a  clerk  is  spent  on  such  matters,  his  salary  is 
charged  to  construction. 

(9)  General  Office  Supplies  and  Expenses: 

With  the  exception  of  a  few  companies  which 
charge  to  construction  those  expenses  occasioned 
by  a  specific  piece  of  construction  work  and  a 
few  which  charge  a  fixed  and  apparently  arbitrary 
percentage  of  general  office  supplies  and  expenses 
to  construction,  the  general  practice  seems  to  be 
to  regard  the  entire  cost  of  these  supplies  and 
expenses  as  a  proper  charge  to  operation. 

(10)  Superintendents'  or  Local  Managers'  Salaries: 

Practices  differ  also  with  regard  to  these  expenses. 
Those  companies  which  charge  any  part  to  con- 
struction usually  attempt  a  division  on  an  actual 
or  estimated  time  basis.  The  policy  of  some  com- 
panies is  to  consider  all  salaries  of  employes 
above  the  grade  of  foremen  as  chargeable  entirely 
to  operation.  The  general  practice,  it  is  safe  to 
say,  is  to  make  no  charge  to  construction  for 
local  managers'  or  superintendents'  salaries. 

(11)  Interest: 

The  existing  practices  with  reference  to  interest 
vary  as  greatly  as  in  the  treatment  of  other  over- 
head charges,  even  though  the  propriety  of  includ- 
ing an  allowance  for  interest  during  construction 
has  been  generally  recognized  in  appraisal  work. 
The  predominant  practice  seems  to  be  to  make  no 
charges  to  construction  on  account  of  interest. 
Among  the  companies  which  have  made  such 
charges  to  construction,  the  practice,  as  indicated 
by  the  replies  received,  is  to  terminate  them  as 
soon  as  the  property  is  turned  over  for  operation. 


8 

In  other  cases  interest  is  charged  to  construction 
only  when  money  has  actually  been  borrowed  for 
construction  purposes.  Others  charge  half  of  the 
legal  annual  rate  on  money  used  for  all  construc- 
tion; in  others  actual  interest  upon  bonds  from 
the  date  of  withdrawal  to  the  time  of  turning  over 
the  property  for  operation  is  charged. 
As  to  discount  on  bonds,  the  general  practice  is  to 
charge  nothing  to  construction. 

The  foregoing  summary,  though  interesting  as  illus- 
trative of  prevalent  practices  among  utility  companies  and 
of  the  lack  of  agreement  among  companies  as  to  the  meth- 
ods which  should  be  followed  in  dealing  with  overhead 
expenses,  gives  us  very  little  ground  upon  which  to  base 
conclusions,  either  as  to  what  overhead  items  are  properly 
chargeable  to  construction  or  as  to  what  is  the  normal  ratio 
between  overhead  and  direct  charges.  For  the  purpose  of 
throwing  some  light,  if  possible,  upon  the  relations  which 
may  be  expected  to  exist  between  overhead  and  direct 
charges,  we  have  summarized  below  the  charges  actually 
made  by  a  number  of  utility  companies,  which  have  been 
verified  by  us.  In  this  summary  construction  expenditures 
are  shown  in  round  numbers  only. 

Company  No.  1 — Period  of  One  Year. 

Per  Cent 
of  Direct 
Charges. 
Total  Direct  Charges— About  $800,000.00. 
Overhead  Charges: 

Engineering  and  Supervision 1.92 

Salaries  of  Officers  and  Managers 1.96 

Salaries  of  General  Office  Clerks 41 

Injuries  and  Damages 17 

Legal 35 

Sundry   Expenses 11 

Interest  During  Construction 28 

Total   5.20 


Company  No.  2 — Period  of  One  Year. 

Per  Cent 
of  Direct 
Charges. 
Total  Direct  Charges— About  $500,000.00. 
Overhead  Charges: 

Interest 94 

Liability  Insurance 94 

Engineering  and  Supervision 5.54 

Office  Clerical  Salaries,  Expenses  and  Miscel- 
laneous   47 

Legal    19 

Total   8.08 


Company  No.  3 — Period  of  Two  Years  and  Ten  Months. 

Total  Direct  Charges— About  $900,000.00. 

Overhead  Charges: 

Engineering  and  Supervision 8.90 

Law  Expenses 47 

Injuries  and  Damages  and  Liability  Insurance  1.07 

Interest  1.20 

Salaries  of  Officers 1.52 

Office  Clerical  Salaries,  Office  Expenses  and 
Miscellaneous 2.21 

Total   15.37 


Company  No.  4 — Period  of  Three  Months 

Total  Direct  Charges— About  $600,000.00. 

Overhead  Charges: 

Engineering  and  Supervision 9.54 

Injuries  and  Damages  and  Liability  Insurance  1.31 

Interest 2.31 

Office  Clerical  Salaries,  Office  Expenses  and 
Miscellaneous 1.46 

Total   14.62 


10 

Company  No.  5 — Period  of  One  Year 

Per  Cent 
of  Direct 
Charges. 
Total  Direct  Charges— About  $800,000.00. 
Overhead  Charges: 

Engineering  and  Supervision 9.44 

Salaries  and  Expenses  of  Office  Employes.  .  .   1.09 

Injuries  and  Damages 1.54 

Interest  1.90 

Taxes   08 

Total   14.05 


Company  No.  6 — Period  of  One  Year 

Total  Direct  Charges— About  $75,000.00. 

Overhead  Charges: 

Engineering  and  Supervision 9.1 

Salaries  of  Officers  and  Managers 4.8 

Liability  Insurance 2.1 

Total   16.0 


Company  No.  7 — Period  of  Two  Years 

Total  Direct  Charges— About  $30,000.00: 

Overhead  Charges: 

Injuries  and  Damages 3.9 

Engineering  and  Supervision 17.0 

Total   20.9 


Company  No.  8 — Period  of  Eleven  Years 

Total  Direct  Charges— About  $300,000.00 : 
Overhead  Charges: 

Engineering  and  Supervision 10.19 

Interest  and  Note  Discount 1.25 

Legal  Expenses 1.23 

Miscellaneous 19 

Total   12.86 


11 

It  will  be  noted  from  the  foregoing  statements  of  over- 
head that  the  practices  of  different  companies  differ  widely 
as  to  the  total  amount  of  overheads  charged  to  construc- 
tion and  also  as  to  the  amounts  charged  for  the  various 
classes.  Engineering  and  Supervision  charges  range  from 
1.92  per  cent  for  Company  No.  1  to  17  per  cent  for  Com- 
pany No.  7.  The  latter  company,  however,  made  only  one 
other  charge  to  overhead,  that  being  for  Injuries  and  Dam- 
ages, amounting  to  3.9  per  cent,  or  a  total  of  20.9  per  cent 
on  a  total  direct  charge  of  approximately  $30,000.00. 

In  the  case  of  Company  No.  1  the  overhead  charges 
for  the  preceding  year  amounted  to  7.46  per  cent  on  a 
total  direct  charge  of  $450,000.00  as  against  5.20  per  cent 
on  a  total  direct  charge  of  about  $800,000.00  as  shown  in 
this  report.  In  the  case  of  this  company  the  overhead 
charges  did  not  increase  in  proportion  to  the  increase  in 
the  direct  charges. 

Because  of  the  differences  in  the  practices  of  companies 
whose  charges  we  have  verified,  it  has  not  been  practicable 
to  classify  the  overhead  items  in  the  same  way  for  all  com- 
panies, but  as  far  as  possible  they  have  been  grouped  so 
that  they  might  be  comparable.  The  foregoing  summary, 
of  course,  represents  only  the  charges  actually  made. 
Where  the  practice  of  a  company  has  been  to  make  no 
charge  to  construction  for  certain  items,  as,  for  example, 
interest  or  taxes  during  construction,  the  summary  above 
does  not  include  such  construction  costs.  Consequently 
the  summary  is  presented  here,  not  as  indicative  of  what 
are  normal  ratios  for  overhead  expenses  but  as  showing 
the  nature  and  importance  of  indirect  construction  charges 
actually  made  by  companies  following  different  policies. 

We  come  next  to  a  consideration  of  the  principles  which 
should  govern  in  the  accounting  treatment  of  overhead 
expenses.  As  to  the  division  between  operating  expenses 
and  construction,  there  are  two  extremes  of  policy.  Under 
one  policy  construction  would  be  charged  with  all  expenses 
which  would  be  incurred  for  such  construction  if  the  com- 
pany were  not  operating.    The  other  extreme  would  be  to 


12 

charge  to  construction  no  expense  which  would  be  con- 
tinued during  a  period  when  there  was  no  construction. 
Under  neither  policy  would  operation  and  construction  be 
dealt  with  as  co-ordinate  functions  of  a  public  utility. 

Either  of  these  extreme  policies  is  difficult  of  accurate 
application.  If  the  policy  is  to  charge  only  the  excess  costs, 
above  what  would  be  the  cost  if  operation  only  should  be 
carried  on,  the  difficulty  is  met  of  ascertaining  what  ex- 
penses would  really  continue  if  construction  were  to  cease 
altogether.  Temporary  cessation  of  construction  would 
probably  not  reduce  the  salaries  of  officers  and  general  man- 
agement, but  if  the  lack  of  construction  means  that  the 
business  has  become  static,  undoubtedly  the  supervisory 
cost  would  tend  to  decrease  below  what  it  would  be  in  a 
company  actively  engaged  in  construction  work.  Hence 
to  charge  all  supervisory  expenses  to  operation  would  tend 
to  charge  more  than  the  actual  requirements  for  operating 
purposes.  If  the  opposite  policy  is  followed  it  is  difficult 
to  determine  what  the  construction  cost  would  be  if  no 
operation  were  carried  on.  Estimating  the  overhead  cost 
of  construction  under  conditions  of  non-operation  cannot 
be  satisfactory.  Although  we  may  conclude  that  proper 
methods  of  handling  overhead  charges  lie  somewhere  be- 
tween the  extremes  denoted,  we  cannot  determine  what 
the  proper  method  should  be  without  considering  the 
question  in  the  light  of  the  effect  which  differences  in 
treatment  would  have. 

The  problem  of  handling  construction  overheads  is  a 
two-fold  one.  If  the  practice  of  charging  a  large  part  of 
overheads  to  construction  is  followed,  the  property  and 
plant  account  will  be  increased;  operating  expenses  will 
be  kept  at  a  minimum  and  the  net  revenue  will  appear  to 
be  large.  Desirable  as  such  a  condition  may  be,  there  is 
another  side  to  be  considered:  that  public  regulatory 
bodies  will  probably  be  reluctant  to  increase  expenses  to 
a  point  higher  than  that  shown  on  the  books;  and  the 
apparently  large  net  revenues,  which  result  from  charging 
to  construction  certain  overhead  items  which  might  have 


13 

been  charged  to  operation,  may  furnish  the  basis  for  a 
reduction  of  rates  by  public  authority.  On  the  other  hand, 
if  the  practice  has  been  followed  of  charging  operation 
with  overhead  expenses  which  really  relate  to  construc- 
tion work,  there  may  be  a  tendency  on  the  part  of  regu- 
latory agencies  to  allow  a  very  small  overhead  on  the 
property  with  the  result  that  a  return  may  be  earned  upon 
less  than  its  true  cost. 

The  solution  of  the  problem,  in  so  far  as  any  solution 
can  be  offered  at  the  present  time,  seems  to  lie  in  han- 
dling overhead  charges  in  such  a  way  as  to  avoid  either 
of  the  extremes  mentioned  above.  Viewing  the  question 
from  the  standpoint  of  accounting  principle,  we  conclude 
that  the  aim  should  be  to  have  the  books  show,  as  closely 
as  possible,  actual  costs,  whether  we  are  dealing  with 
property  accounts  or  with  operating  expenses.  The  principle 
is  not  different  from  that  which  should  govern  in  the  division 
of  operating  expenses  between  different  classes  of  busi- 
ness conducted  by  a  public  utility.  If  a  company  operates 
both  gas  and  electric  departments  the  cost  of  neither 
department  would  be  correctly  shown  by  charging  to  it 
only  the  direct  costs  or  only  the  direct  costs  plus  such 
part  of  overhead  costs  as  could  be  dispensed  with  by  the 
other  department  if  that  department  were  operated  sep- 
arately. Normally,  the  two  departments  would  be  treated 
as  co-ordinate  and  the  books  would  show,  as  nearly  as  pos- 
sible, the  actual  cost  of  each,  with  joint  overhead  operat- 
ing expenses  divided  in  such  a  way  as  not  to  unduly  burden 
either  department. 

Although  there  may  be  exceptions  in  the  case  of  util- 
ities in  cities  where  the  physical  properties  have  reached 
practically  their  limit  of  expansion,  the  normal  present  con- 
dition in  the  public  utility  business  is  one  of  growth  and 
extension.  With  such  protection  from  competition  as  is 
afforded  by  their  franchises,  public  utilities  are  generally 
regarded  as  being  no  less  obligated  to  extend  their  service 
and  facilities,  within  reasonable  limits,  than  they  are  to 


14 

supply  service  to  customers  already  connected.  This  being 
so,  there  seem  to  be  two  functions  which  a  company  should 
perform,  neither  of  which  can  be  regarded  as  incidental, 
although  expenditures  may  be  greater  for  one  than  for  the 
other.  These  functions  are  to  supply  service  to  present 
customers  and  to  extend  service  to  others.  Proper  ac- 
counting should  aim  to  show  the  full  cost  of  performing 
each  of  these  functions.  It  follows  that  in  order  that  the 
cost  of  each  may  be  correctly  shown,  expenses  which  are, 
in  fact,  overhead  to  both  operation  and  construction, 
should  be,  in  practice,  divided  between  operation  and  con- 
struction. 

Because  of  the  importance  of  estimates  of  the  cost  of 
reproduction  in  the  valuation  of  utility  properties  and  the 
very  general  classification  by  appraisers  of  certain  classes 
of  construction  expense  as  overhead,  the  term  "Construc- 
tion Overheads"  has  come  to  have  a  more  or  less  gener- 
ally accepted  meaning,  not  in  all  respects  identical  with 
the  accounting  definition.  In  its  general  acceptance  the 
term  includes  some  items  of  cost  of  construction  which  in 
practice  may  be  charged  directly  to  specific  pieces  of  con- 
struction. The  result  of  this  and  of  the  failure  of  many 
utilities  to  charge  to  construction  certain  actual  costs 
has  been  a  great  deal  of  confusion  and  misunderstanding 
in  dealing  with  the  allowance  for  overhead.  Best  results 
will  probably  be  obtained  when  the  accounting  practice 
is  brought  into  as  close  harmony  as  possible  with  the  ac- 
cepted engineering  practice. 

A  first  essential  in  connection  with  a  discussion  of  the 
procedure  which  should  be  followed  with  regard  to  over- 
heads, is  an  understanding  as  to  what  are  overhead  ex- 
penses. The  bare  cost  of  material  and  direct  labor  em- 
ployed in  construction  work  may  clearly  be  regarded  as 
direct  charges.  In  so  classifying  these  items,  however, 
we  are  immediately  confronted  with  the  question  of  how 
transportation  and  handling  charges  on  material  should  be 
treated  and  also  how  certain  expenses  of  direct  supervision 
should  be  dealt  with. 


15 

We  regard  freight  not  as  an  overhead  cost,  but  as  a 
direct  cost,  and  the  general  practice  of  valuation  engineers 
seems  to  be  to  treat  this  as  a  direct  addition  to  the  bare 
cost  of  materials.  In  addition  to  the  bare  cost  of  mate- 
rials and  freight,  we  are  of  the  opinion  that  the  cost  of 
handling  material,  including  storeroom  expenses  and  the 
cost  of  hauling  material  to  the  point  of  use,  is  more 
properly  a  direct  charge  than  an  overhead.  The  cost 
of  hauling  is  not  materially  different  from  the  cost  of 
freight,  merely  because  the  hauling  may  be  done  by  the 
company  itself.  If  the  hauling  is  done  by  other  parties, 
its  cost  is  clearly  of  the  same  nature  as  freight,  and  the 
fact  that  the  public  utility  does  its  own  hauling  does  not 
alter  the  circumstances.  To  be  sure,  the  use  of  utility  equip- 
ment in  connection  with  construction  generally  makes  it 
necessary  to  divide  utility  equipment  expenses  between 
operation  and  construction.  This  does  not  mean,  how- 
ever, that  these  are  overhead  expenses.  The  apportion- 
ment between  operation  and  construction  can  probably 
best  be  made  on  the  basis  of  time  used,  and  the  construc- 
tion portion  of  the  cost  charged  directly  to  the  construc- 
tion job.  This  practice  is  followed  by  a  number  of 
utilities  whose  records  we  have  examined. 

Storeroom  expenses,  also,  are  usually  joint  expenses 
of  operation  and  construction,  but  the  portion  which  is  a 
construction  charge  is  not  really  overhead  to  all  construc- 
tion work,  but  relates  to  the  handling  of  material  so 
closely  that  it  may  be  properly  treated  as  a  direct  charge 
upon  the  basis  on  which  material  is  charged.  The  clerical 
work  of  keeping  storeroom  records,  although  somewhat 
less  directly  an  addition  to  the  cost  of  materials  than  the 
cost  of  handling,  nevertheless  represents  a  cost  in  connec- 
tion with  the  use  of  materials  for  construction  work  and 
should,  in  our  opinion,  be  added  directly  to  the  cost  of 
materials. 

The  cost  of  direct  supervision  of  labor,  such  as  wages 
of  construction  foremen,  is  handled  reasonably  as  a  direct 
labor  cost  and  should  not  be  included  with  overheads. 


16 

With  the  elimination  of  the  items  mentioned  above  which 
we  would  treat  as  direct  charges,  the  term  "overhead" 
may  be  understood  to  include  the  following: 

1.  Engineering  and  Supervision. 

2.  Salaries  and  Expenses  of  Officers. 

3.  Office  Salaries. 

4.  Office  Supplies  and  Expenses. 

5.  Legal  Expenses. 

6.  Injuries  and  Damages  and  Liability  Insurance. 

7.  Taxes. 

8.  Interest  and  Bond  Discount. 

The  cost  of  engineering  and  general  supervision  seems 
to  be  clearly  an  overhead  charge.  A  plausible  argument 
may  be  advanced  for  handling  part  of  the  cost  of  engineer- 
ing as  a  direct  labor  charge  to  construction,  but  we  con- 
sider it  better  practice  to  follow  a  uniform  policy  for  all 
items  of  engineering  and  general  supervision.  The  gen- 
eral practice  of  appraisal  engineers  is  to  set  out  the  cost  of 
engineering  and  supervision  apart  from  the  unit  cost  of 
labor  and  materials  charged  directly.  It  seems  desirable 
that  the  accounting  policy  be  consistent  with  the  policy 
followed  in  engineering  valuations,  if  such  consistency 
can  be  obtained  without  doing  violence  to  accounting 
principles.  Although  it  would  undoubtedly  be  feasible  to 
charge  a  part  of  engineering  and  supervision  cost  as  direct 
labor,  in  our  opinion  such  cost  is  actually  overhead  to  the 
prime  costs  of  construction  work.  When  engineering  and 
supervision  work  is  done  by  a  holding  company  and  the 
charge  for  such  work  is  a  percentage  of  the  cost  of  labor 
and  material  directly  employed  for  construction  purposes, 
the  necessities  of  the  case  practically  require  its  treatment 
as  an  overhead  expense.  The  policy  to  be  adopted  for 
handling  such  cost  should  be  such  that  the  treatment  of 
the  cost  of  engineering  and  supervision  will  be  consistent, 
whether  this  work  is  done  by  a  holding  company,  by  the 
regular  staff  of  the  utility,  or  by  a  staff  specially  engaged 
for  the  work. 


17 

Salaries  and  expenses  of  officers  are  often  handled  by 
utility  companies  as  being  entirely  expenses  of  operation. 
Such  companies  take  the  attitude  that  such  expenses  must 
continue  even  when  no  construction  work  is  under  way 
and  therefore  the  entire  amount  should  be  charged  to  opera- 
tion. Although  it  is  important  that  the  method  of  divid-* 
ing  such  salaries  between  operation  and  construction  be 
established  with  great  care  in  order  not  to  overburden 
construction,  the  actual  cost  of  construction  work  will  not 
be  shown  on  the  books  unless  a  fair  share  of  officers'  sal- 
aries is  charged  to  such  work.  That  portion  of  salaries 
and  expenses  of  officers  which  is  charged  to  construction 
is  clearly  overhead  in  its  nature. 

Although  it  is  possible  that  some  portion  of  office  sal- 
aries might  be  charged  directly  to  specific  pieces  of  con- 
struction work,  we  are  of  the  opinion  that  such  salaries 
are  clearly  overhead  in  that  they  do  not  relate  directly  to 
the  handling  of  construction  material  or  to  direct  super- 
vision of  labor.  The  division  between  operation  and  con- 
struction must,  of  course,  be  carefully  made  in  order  not 
to  overcharge  construction.  What  has  been  said  of  office 
salaries  holds  true  of  office  supplies  and  expenses,  and  no 
further  discussion  of  these  items  is  required. 

Legal  Expenses  incurred  in  connection  with  construc- 
tion are,  in  our  opinion,  proper  overhead  charges.  Although 
it  would  be  possible  in  some  instances  to  charge  a  part  of 
these  expenses  to  particular  items  of  construction,  such  as 
legal  expenses  relating  to  the  acquisition  of  land,  such 
expenses  are  not  in  the  nature  of  prime  costs  and  should 
be  treated  as  overhead.  Legal  expenses  for  construction 
purposes  may  vary  in  their  nature,  and  include  such  ex- 
penses as: 

(a)  Legal  expenses  in  connection  with  the  purchase  of 

land. 

(b)  Legal  expenses  in  connection  with  injury  and  dam- 

age claims. 

(c)  Legal  expenses  in  connection  with  contracts,  etc. 

(d)  Indirect  legal  expenses  considered  as  general  office 

expenses. 


18 

All  classes  of  legal  expenses,  however,  are  overhead  in 
nature.  Whether  they  should  all  be  charged  to  one  ac- 
count, "Legal  Expenses  During  Construction,"  or  whether 
portions  of  them  should  be  charged  to  other  accounts, 
such  as  "Injuries  and  Damages  During  Construction,"  is 
a  matter  to  be  determined  with  reference  to  the  classifica- 
tion of  accounts  used  by  the  company  concerned,  but  this 
does  not  affect  their  status  as  overhead  expenses. 

Accidental  Injuries  and  Damages  and  Liability  Insur- 
ance are  construction  costs  which  it  would  often  be 
practicable  to  charge  directly  to  the  job  to  which  they 
relate.  In  the  case  of  a  charge  for  Liability  Insurance, 
where  the  premiums  are  based  on  the  payroll,  it  would  be 
feasible  to  distribute  the  cost  on  the  basis  of  construction 
payroll  distribution  and  charge  it  directly  to  the  various 
items  of  construction.  Injury  and  Damage  awards,  too, 
could  in  many  cases  be  charged  directly  to  that  part  of 
construction  work  where  the  injury  or  damage  occurred. 
We  are  of  the  opinion  that  this  is  not  the  test.  Direct 
charges  should  include  only  those  costs  which  may  be 
classified  as  prime  costs,  and  the  cost  of  insurance  and  of 
accidental  injury  and  damage  claims  is  not  a  direct  prime 
cost  which  actually  furthered  the  work  of  construction. 
Moreover,  the  handling  of  these  costs  as  overhead  is  con- 
sistent with  the  policy  of  engineers  in  valuation  work. 

Taxes  assessed  during  the  period  of  construction  should 
be  charged  to  construction  as  an  overhead  expense.  The 
correctness  of  this  policy  seems  to  be  generally  recognized, 
although  a  great  many  companies  are  not  applying  it  in 
practice,  especially  as  to  miscellaneous  construction  not 
covering  a  long  period  of  time. 

Interest  during  construction  seems  to  be  regarded  ordi- 
narily as  an  overhead  construction  cost,  although  many 
companies  have  not  charged  to  construction  the  full  amount 
of  interest  pertaining  thereto.  It  is  generally  held  that 
when  money  is  actually  borrowed  for  construction  purposes 
the  interest  on  such  money,  up  to  the  time  that  construe- 


19 

tion  work  is  completed,  should  be  charged  to  construction 
as  an  overhead. 

.Whether  a  charge  for  interest  during  construction 
should  be  made  for  the  use  of  funds  provided  by  the  sale 
of  stock  is  a  disputed  question.  The  classifications  issued 
by  state  commissions  do  not  definitely  authorize  such  a 
charge.  The  practice  generally  provided  by  such  classifi- 
cations has  authorized  interest  charges  to  the  amount  of 
interest  paid  on  borrowed  capital,  and,  at  least  impliedly, 
has  limited  such  charges  to  the  amount  of  such  payments. 
In  accounting  terminology  dividends  constitute  a  dispo- 
sition of  net  income  rather  than  a  payment  of  interest. 
The  Interstate  Commerce  Commission,  however,  recognizes 
as  a  proper  charge  for  interest  during  construction  a  rea- 
sonable amount  for  the  use  of  the  company's  own  funds. 
As  a  general  rule,  part  of  the  funds  used  for  construction 
must  be  funds  of  the  company.  The  borrowing  power  is 
ordinarily  limited  to  about  75  per  cent  or  80  per  cent  of 
the  amount  expended  for  construction.  Some  utility  com- 
panies finance  a  relatively  large  part  of  their  construction 
by  the  sale  of  stock.  Others  find  it  desirable  at  times  to 
finance  extensions  by  stock  sales,  although  at  other  times 
bonds  would  be  sold  to  provide  the  funds.  In  any  case, 
if  the  charge  to  construction  is  limited  to  a  reasonable 
amount  for  the  use  of  the  company's  own  funds,  such  a 
charge  is  really  for  interest  on  capital  furnished  and  as 
such  constitutes  a  part  of  the  cost  of  construction  work 
which  may  properly  be  included  in  the  charges  to  fixed 
capital. 

Inasmuch  as  this  discussion  deals  only  with  the  pro- 
priety of  charges  to  construction,  we  will  not  attempt  at 
this  time  to  deal  with  the  question  of  the  proper  distribu- 
tion of  the  credit  necessitated  by  a  charge  to  construction 
for  interest  on  the  company's  own  funds.  This  credit 
might  conceivably  be  shown  as  an  addition  to  Surplus, 
which  might  or  might  not  result  in  its  being  distributed 
in  dividends,  or  to  a  Reserve  or  Special  Surplus  account, 
which  would  not  be  available  for  dividends. 


20 

That  portion  of  bond  discounts  which  relates  to  the 
construction  period  should  also  be  an  overhead  charge  to 
construction,  being  in  reality  merely  interest  paid  in  ad- 
vance. 

Although  we  consider  it  desirable  to  maintain  a  dis- 
tinction between  direct  and  overhead  charges  so  that  the 
identity  of  overhead  charges  may  not  be  lost,  it  may  be 
well  to  classify  such  overhead  items  as  admit  of  such  treat- 
ment, according  to  the  grouping  of  direct  charges.  The 
possibility  of  so  distributing  overhead  charges  has  led  to 
some  confusion,  and  some  companies  have  so  kept  their 
accounts  that  only  an  exhaustive  examination  of  construc- 
tion charges  will  disclose  their  nature  and  extent.  Con- 
sequently, it  would  appear  to  be  the  better  plan  to  first 
charge  all  overhead  items  to  distinctive  accounts,  which 
may  then  be  cleared,  if  desired,  by  spreading  them  over  the 
various  construction  accounts  set  up  under  the  particular 
classification  in  use. 


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THIS  BOOK  IS  DUE  ON  THE  LAST  DATE 
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WILL  INCREASE  TO  SO  CENTS  ON  THE  FOURTH 
DAY  AND  TO  $1.00  ON  THE  SEVENTH  DAY 
OVERDUE. 


'''^"^•U31 

MAR    6  1936 

260d5ICr 

v^-^ 

l.t'^ 

LD  21-100m-7.'33 

SC  92683 


UNIVERSITY  OF  CALIFORNIA  LIBRARY 


t       .4 


-Suit 


'■"Ai?^ 


